Why blacklisting doesn’t work

The arrest of Finmeccanica Chairman and CEO, Giuseppe Orsi, has finally jolted the Indian defense ministry into action, after a year of media reports on the unfolding scandal of corruption in the Indian purchase of 12 VVIP AgustaWestland AW101 helicopters. Predictably, Defense Minister Arackaparambil Kurien Antony has called in the Central Bureau of Investigation (CBI) to look into the matter and promised to blacklist the company if they are found guilty.

There are several problems with this. First of all, while many foreign arms companies are blacklisted in India, not a single one has ever been found guilty in a court of law in India.

Blacklisting is a politician’s response, that serves no purpose for either the Indian armed forces or the taxpayer.

Blacklisting is how the politician cops out of responsibility for ensuring a corruption-free defense acquisition process or, alternately, ensuring that justice is served when arms companies violate Indian laws.

Blacklisting is effectively the application of rules that govern PWD (Public Works Department) contracts like building a road in a lane of Old Delhi, on an industry that is extremely competitive and technology intensive, wherein only a handful of companies, worldwide, have made the investments to develop the technologies that the Indian armed forces require.

Here’s how this plays out.

Indian defense procurement has long been maimed by corruption allegations and the inquiries that ensue, which ensure the freezing of the defense acquisition process whenever such allegations are raised. Although recent instances have shown that mere allegations are not always sufficient to bring the process to a standstill, these instances have been the exception in a series of frustrations that the Indian armed forces have experienced in their efforts to modernize.

Certainly, a large part of the problem is the opacity of the process, deemed necessary in the interests of national security.

But it is also clear that measures to minimize the occurrence of corruption, too, leave much to be desired. While the now-regularly updated Defense Procurement Procedure of India may have much to say on the subject (which it says to the bewilderment of the average reader), for an observer at 30,000 feet, it appears that the system remains game for players of a dubious kind.

Firstly, corruption allegations are often used as a tool by competitors to stymie the process of acquisition of a particular piece of equipment, to the detriment of those vendors who appear to have a stronger case. The losers here are the armed forces that have to go without.

Secondly, the Indian criminal justice and judicial system are out of their league in trying to deal with and match the resources of those with the deep pockets normally imagined to be possessed by the defense industry. The Indian government has scant success to show in its efforts to investigate and prosecute instances of corruption in defense procurement. As mentioned earlier, not a single foreign arms company or arms agent has ever been successfully prosecuted.

And thirdly, the usual sentence of blacklisting, to which a company is subjected when it receives, without any administrative or judicial process, in the normal course, the quiet accusation and condemnation of nameless civil servants in the Ministry of Defense, is again to the disadvantage of the armed forces.

Defense industry, being highly specialized in terms of technology and producing defense materiel that is usually highly confidential, is driven by the competition for the technological edge. There are inevitably no more than a handful of companies that have the ability to produce a particular piece of equipment at a certain rate.

Blacklisting companies has the potential to deprive the armed forces of the chance to gain equipment with technologies that are quite possibly not available anywhere else. And even if that particular equipment is available somewhere else, blacklisting one contender from the bidding process is sure to drive up the rates of comparable products in general.

What is required is a policy for minimizing corruption in defense deals, ensuring value for money to the taxpayer and securing defense acquisition by the armed forces.

This predicament requires a different approach, which should have the following objectives:

a. The interests of justice must be served. If there is wrongdoing, the offender must suffer to make right.

b. The Indian taxpayer must not be allowed to be cheated or made to end up, in anyway, paying more than is merited for a piece of equipment. At the end of the day, it is the taxpayer who is wronged by any kind of corruption.

c. The process of acquisition by the armed forces must be secured from the vagaries of corruption allegations and even proven instances of corruption, and continued delivery of materiel to them must be guaranteed, even from a corrupt deal.

At this point, it is important to note that corruption in defense procurement rarely happens at the trials’ stage. While the armed force in question may not pick the best possible piece of equipment in question, it will almost certainly be due to the requirement of the force. The product selected will almost certainly fall within the stated requirements of the armed forces. In any case, at the end of trials the various products short-listed by the army, navy or air force are usually comparable in terms of features and quality. The question of pricing is not one that that any of the three forces decide. This decision is taken by the civil service in the Ministry of Defense.

To carry on, the objectives laid down above need an approach that is

a. Punitive: The offending vendor must suffer financial punishment automatically. Ordinary criminal law and the laws against unjust enrichment can then chase guilty government officials, middlemen, brokers, commission agents, company officials and representatives.

b. Restitutive and/or Compensatory: Depending on the advantage to the taxpayer, restitution and/or compensation must be made by the company for unlawful profits made by the company or losses suffered by the taxpayer. It is important to note that legally, restitution and compensation refer to two different forms of damages. While, restitution is made to the value of the unlawful gains made by an offending party, compensation is made for losses suffered by the victim.

c. Other damages: Incidental damages, consequential damages, reliance damages, statutory damages and legal/administrative costs may also be valued and imposed. It is also important to note that other remedies, such as specific performance of contract and account of profits may also be utilized to ensure justice.

All of these damages may be designated as either liquidated or at large at the time of contract.

Yes. But how will this work?

The defense procurement process will require a reformulation with additional stipulations to which all bidders for a contract will have to agree in advance. To be fair, some of this already exists in defense ministry policies, but has virtually never been invoked. In fact the first time the integrity clause was invoked was last year, when the bank guarantee of Israel Military Industries (IMI) was seized after the company was blacklisted.

These stipulations will incorporate the above damages as either liquidated damages or damages at large, depending on the facts and circumstances of the case.

We also have to get rid of the opacity in the process. To bring transparency a body comprising officials from the Ministry of Defense and possibly the Law Ministry and/or Home Ministry will have to be designated to decide on matters of corruption.

This is already done by officials in the Ministry of Defense in their existing capacities as authorities that opine and rule on the existence of corruption, wrongdoing or impropriety in a particular contract, and the issue of blacklisting or the pressing of criminal charges.

In a case where it is found by the designated body that corruption or other impropriety has taken place in a defense contract, the offending vendor will be subject to the damages mentioned above.

But in no case should a contract be cancelled or a company blacklisted unless it is found that the equipment in question is one which does not fit the requirements of the armed forces.

Instead the offending vendor should be made subject to, firstly, punitive damages. These are damages that can be decided and agreed at the time of contract. For example, in such a case the vendor would be required to pay or deliver in materiel, say, thirty per cent of the value of the original contract, over and above the existing deal. This is where the integrity pact comes in, already. The defense ministry needs to start using it, routinely.

Secondly, the taxpayer must be compensated for any losses incurred due to the payment of bribes or kick-backs. So the value of the money paid by the taxpayer and spent on corruption by the vendor must be repaid to the state in terms of compensatory damages.

Also, in case the vendor has made gains from corruption, besides the amount agreed in the contract, any such unlawful gains must also be rendered to the state. For one small instance, if a vendor supplies a piece of equipment with substandard parts, while making a profit off the sale of the desired-quality parts, the amount of such profits must also be paid to the state and the taxpayer as restitutive damages.

Further, if the state and taxpayer suffer losses that are incidental to or a consequence of the corruption perpetrated by the vendor, they would be entitled to incidental and consequential damages as well. If they suffer losses because of the reliance placed on a vendor who fails to fulfill their obligation due to corruption, they may be entitled to reliance damages as well. To further punish the offender, the state may impose statutory damages and also recover legal and administrative costs.

These damages will take the shape of fines imposed on the offending vendor and will be the additional stipulations to which all bidders will have to agree in advance.

At the end, to serve the interests of natural justice, there needs be an appeals process that could take the form of hearing before a tribunal or an arbitrator.

Importantly, it should be noted that since no contract is cancelled, save in the case of a product falling below selection criteria, deliveries to the armed forces will not only carry on, but will be enhanced by thirty per cent or any other percentage decided.

This approach will achieve the three objectives of punishing the offender, making good the losses suffered by the taxpayer as well as ensuring the continued delivery of materiel being acquired by the armed forces.

It must also be noted that it is unlikely that any vendor would find itself in a position to openly oppose the principle of being subject to the fines laid down above, since no vendor would admit to the possibility of indulging in corruption or impropriety.

This approach is not a silver bullet that will remove corruption from defense procurement. There will always be confident adventurers cocky enough to try and beat the system, government officials who allow themselves to be tempted and companies eager enough for contracts to risk wrongdoing.

Instead it is a way of making it prohibitively expensive for vendors to indulge in corruption or impropriety. Since it is the vendors that have the most to gain or lose, it is they who must be held responsible, first and financially. Also, since the pursuit of offending vendors through the criminal justice system has never really worked, this is a way of pinching offending vendors with fines where it hurts – their pockets, while at the same time ensuring value for money for the taxpayer and continuity in defense acquisition and modernization by the armed forces.

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The out of the box scheme of the Ministry of Defense was destined to fail. The plan was to accept the concept of agents and middleman in the trade of defense equipment, however grudgingly, with strict terms and voluntary registration. The idea was to try and emulate the concept of registered lobbyists as is practiced in countries like the United States.

It was quickly shelved after receiving zero response.

More than a decade after it was proposed and then quickly scrapped, it remains the only real solution to much of the corruption in the defense trade, the regulations of which simply drive it underground by considering commission agents an unlawful element of the market.

The notification of November, 2001, said, “The entire policy has been extensively reviewed recently with the objective of defining the scope, extent and the conditions within which such Authorized Representatives\Agents may be allowed to represent a foreign supplier or suppliers.”

The defense ministry admitted after an ‘extensive review’, “While it is not the policy of Government to encourage agents if the requisite supplies could be obtained and satisfactory after-sales service ensured, on reasonable terms, without their intercession, upon detailed examination the Ministry of Defense, concluded that there are advantages in involving Authorized representatives\Agents.”

The ministry reasoned, “Such an involvement of Authorized Representatives\Agents would enhance transparency levels, provide the Service HQs with additional information about latest advances in sophisticated combat and non-combat technology. Authorized Representatives\Agents would also be of assistance in trial evaluation of the systems, price negotiations, enhance the quality of after-sales service, resolving performance and warranty issues. Payments to Authorized Representatives\Agents would be covered under the Income Tax Act and attract Income Tax which would be deducted at source.”

Sounds like a great plan. So why didn’t it work?

The notification was intended to cover ‘the regulation of representational arrangements through a system of registration; categorical and open declaration by the foreign suppliers of the services to be rendered by their Authorized Representatives\Agents; and the remuneration payable to them by way of fees, commission or any other method.’

In other words, the defense ministry offered a scheme to arms dealers and agents to voluntarily register themselves so that their business could be monitored and access regulated and their income presumably made taxable. In exchange for nothing. No incentive. And no disincentive either. It was designed to fail.

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